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In the financial markets, seemingly small events are later identified as the first signs of bigger trouble that was brewing. Since only hindsight is 20/20, were only left wondering whether the Archegos Capital Management issue is more than an isolated one.
In Could the Nomura/Credit Suisse selloff be the canary in the coal mine?, we have analysed the issue at hand, of how excessive leverage can cause grief. If credit default swaps attained infamy in the 2008 scam, the product in the limelight this time is contracts for difference (CFD). The more innocuous the name, the more sinister the financial engineering.
In a CFD, a fund takes a position in a stock using a bank as an intermediary. If the trade is in profit on the settlement date, the difference is paid by the bank to the fund. The fund takes a leveraged exposure by paying a small margin, allowing it to earn higher profits than if it had taken a fund-based punt, while the bank earns a commission for its services. When the going is good everyone is happy. But when it isn’t, then it comes down to the fund’s ability to make good with collateral. Archegos’s inability to do so has triggered a selloff by banks.
What were these banks doing in the first place, is the question this article from the FT asks Archegos poses hard questions for Wall Street (free to read for Pro subscribers). While the antecedents of the founder were known—Bill Hwang had paid $44mn to settle insider trading charges in the US—the fund’s status as a family office meant they were exempt from the disclosures expected of hedge funds. The banks’ due diligence appears to have fallen short. Also, the banks appeared to be unaware of other banks having similar exposures, which meant they were not alone when they tried to encash collateral and sent prices crashing.
The issue for the markets is whether this episode could cause a systemic risk. These cases remind one of the 2008 financial crisis and even the LTCM one. The answer appears to be negative for now, but we think it may prompt more scrutiny by the regulators into such opaque products and into funds that are lightly regulated, such as family offices. The FT article also points to the risk of investment banks going back to see how much leverage they are offering to clients such as hedge funds and if need to lower their exposure. Collective action of these types could then lead to a selloff that could hurt investors worldwide.
As we await the consequences, one thing is clear. The actors and financial jargon may be new, but the script is familiar. A flood of money has been unleashed by central banks in the wake of the pandemic, who have now committed to keep policy easy for years, in a bid to support the real economy. But the financial markets have ideas of their own in such times. Complex instruments with linkages that are not visible to investors or regulators turn into bigger risks, because of the amount of liquidity in the system. When some of these risks blow up, then the shaky legs of various financial transactions and their real-world linkages across different markets and countries come to the fore. Greensill’s troubles, for instance, came to the fore during the pandemic. One banker, Credit Suisse, is exposed to both Greensill and Archegos.
Investing insights from our Research team:
Kalyan Jewellers: Weak listing; are there better alternatives?
Suryoday’s poor listing isn’t a surprise, but is it worth at this price?
Railway engineering sector: Back on track
More from our Opinion team
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What else are we reading today?
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Courtroom win is only a small part of Tata-Mistry battle
The questions against electoral bonds must not be brushed aside
International funds deliver: How to pick the right global MF scheme
Technical picks: IFB Industries, Godrej Consumer, ICICI Bank and Bank Nifty (These are published every trading day before the markets open and can be read on the app)